Cost-cutting Leads to Turbulence in the Airline Industry

Is it possible to retain brand value after cutting costs and services dramatically just to stay alive? The airline industry has struggled with this question since deregulation in 1979 in the face of economic downturns, changes in market structure, and shifting clientele. Assistant Professor Susanna Gallani discusses a central lesson from her case study (co-authored with Professor Eva Labro), "RegionFly: Cutting Costs in the Airline Industry." The issue is faced by many companies in many industries: How does a leadership team look past pure survival to regain and even exceed market position.

Brian Kenny: Ah, the golden age of air travel, when giants like Pan Am and TWA ruled the skies, people dressed up for their flights and lined up for photos before boarding, when the government set the price for tickets, and the only way to compete was on customer service. Cue the free booze and real china. Then along came deregulation in 1978 and everything changed, but not necessarily for the worse. Deregulation created price wars and tickets dropped an average 30 percent--but those airlines that distinguished themselves on premium service had to chart a new course.

Susanna Gallani's research focuses on issues related to the design and effectiveness of incentives, including CEO performance and measurement systems linked to compensation contracts. Thanks for joining us today.

Susanna Gallani: Thank you for having me. It's a pleasure.

Kenny: I loved this case, the golden age. We always look at these things through rose-colored glasses. I'm sure that air travel in the golden age probably wasn't that great for a lot of reasons, but I think people will be able to relate to this case because we all travel, we all have our own experiences. Let me just ask you to begin by setting up the case for us. Who are the protagonists and what's going on?

Gallani: We are catching these two protagonists at the moment where they have to make a very serious recommendation that might impact the future of the company. They are at a crossroads. They have tried to keep this company alive in some ways, facing economic downturn challenges and changes in their market structure, changes in their clientele. They are at the point where they're really looking ahead and not seeing the picture that they want to see. They have been asked to provide a recommendation as to whether they should cut one more of the remaining five routes that this airline serves in order to control costs and get back to profitability. They have been tasked by their new owners, because this company has recently been acquired, to make a recommendation. They're struggling with it because there are obviously serious implications.

Kenny: I should say for our listeners at the outset, this is not a real company. Why did you choose to do it that way?

Gallani:We really wanted this case to be appealing to a large audience and serve for many purposes at many different levels of education. We thought that providing a clean setting that is realistic enough but not confounded by all the other things that we find in our messy truth, it was an effective way to do it.

Kenny: Describe RegionFly for us. What's their evolution and how did they make their mark in the world?

Gallani: RegionFly was founded in the early '70s, so at the tail end of what you described in your introduction as being the golden age of air travel, where travelers who would choose flying as their means of transportation would be a small portion of the population, very wealthy, willing to pay a high price tag for the experience. It was a very glamorous outlook on the airline industry.

RegionFly started off at the tail end of that time, an interesting time because it comes between those two historical landmarks. One is the golden age of air travel we just discussed, and the other one is the other event that you mentioned in your introduction, which is the deregulation in '78. They start off on a very good note where the market is ready, there is a clientele for their service. They operate in a very small niche of the market, and they serve premium air travel services in a very small range of routes. They have an established clientele that knows what they're getting, and they're willing to pay the higher price tag for the type of service they're getting.

Now, '78 comes along and things change dramatically for this company, but because their original CEO, who was the founder, had this very clear strategy in mind of keeping their size small and focusing on quality, focusing on value for their customers, actually weathered the storm for a long time. It is only in the 2008-2009 time where things really fall apart. The entire airline industry had been hit pretty hard, and certainly luxurious services like premium air travel were among the first things to go. Now they are in the situation where they're trying to keep their company alive, but they have to deal with a completely different market structure and type of clientele.

Kenny: And a lot of other forces are coming to bear at that time. In a post-recession world we all experienced cutbacks in travel budgets. Business class became sort of a thing of the past, airlines were introducing more technology so maintenance costs went up, all those sorts of investments go up. In better times, what was the culture at RegionFly like?

Gallani: It was all about the service. They would go all the way, without considering too much the cost implications, because they had a clientele that was willing to pay the price. They were not necessarily a frugal company, by any stretch of the imagination, but they were very focused on providing value for the price.

Kenny: Probably a certain sense of pride that went along with working there. What was it like to work at RegionFly in the good days?

Gallani: It was all about distinguishing themselves from others because they were better, because they were providing this higher level of service, and they were very, very focused. Being a small company, you can imagine there was a lot of a family feeling--we're in this together. They were all driving in the same direction.

Kenny: I think there are many things you could relate this to outside of the airline industry, because many firms establish themselves and their brands as a premium brand of one sort or another. We work at Harvard Business School, I guess we fall into that category as well. How does this relate in your mind to other industries?

Gallani: The example of Harvard Business School is a very fitting one, because we strive to provide a high level of service and a high level of quality to our customers and to our students, and that comes at a cost. Sometimes it is difficult to justify the high price tag if you're not aware of the type of value you're getting for your money.

Kenny: RegionFly brings in some consultants, what do the consultants tell them?

Gallani: The recommendations they're bringing along are, first, cut costs across the board, which we have all heard at some point in our lifetime somewhere. The other recommendation is to identify a minimum threshold of profitability for their different routes, the different services they're offering, in order to identify candidates for elimination.

Now, these two recommendations, we really want our students to attack them and discuss them in detail because they have serious consequences.

Kenny: Dive into that a little bit for me. Cost-cutting is at the core of the brand. If you do that, aren’t you gutting the brand.

Gallani: Exactly. By cutting costs across the board, and the type of cost-cutting they are proposing, really goes into the amenities and the little things that make the flying experience better. I don't know if you have experienced this in your flight history, but I know that at some point we saw, when you were traveling with certain larger airlines across the Atlantic, a little bag of amenities would be given to you--and then suddenly they weren't there anymore. Now, is that going to change dramatically the quality of the flight? Maybe not, but customers notice that. When you charge a customer a very high price for a service that comes across as not keeping your end of the deal. That might have implications on their customer base, and some customers might decide that they are not willing to pay the high price tag anymore.

Kenny: There are some airlines who have staked their brand on the opposite extreme. I forget which one it is that charges people to use the restroom. They're charging for baggage, they're charging for every little fee. Can RegionFly credibly move in that direction, or would that be...

Gallani: That would be a complete distortion of their culture and the way they do business, which is part of the reasons why the employees of the company don't like these recommendations that the consultants are bringing along.

Kenny: The changes that are being recommended here are going to fundamentally change the experience of working for a place like RegionFly. How does an organization deal with these kinds of recommendations that come from outside, frankly, that maybe the consultants don't understand us? Does this come up in the classroom discussion at all?

Gallani: It does. It does, because there is this huge tension underneath this decision, and whether to go with the recommendation of the consultants or not will dramatically change the way people work there, the type of priorities they have. There is obviously resistance toward this, people coming from the outside that have not been here all along, and it seems now it's all about the money. That's one problem.

The other problem is that we're talking about cost-cutting, and in general, employees, when they hear those words, start worrying about their own job, or the survival of the company more broadly. The first implementation of similar measures had been done in the past, and people got a little bit excited because these were portrayed as measures that would actually save the company and make things better for the future. Now we're facing a situation in which they didn't work.

The question on the table, at the point we position the case, is should we do it again? Is the problem that we didn't do it aggressively enough, or is the problem that we really made the wrong decision and we should do something else? That is the question at the core of the problem that the CFO and the chief of strategy are facing.

Kenny: Now, we talked a little bit before about the tensions in the classroom and how this surfaces. How do students react to this? I'm curious a little bit about the difference how an MBA student thinks about it and how an executive education student might think about it.

Gallani: First of all, the reason we provided this cleaner, simplified setting is to help undergraduate students grapple with business situations that they might not have been exposed to just yet. The undergraduate students try to focus more on the big signals and the big problems. When you teach this case in an MBA class or an executive education class, you get an enormously rich discussion because everybody has faced similar problems some way, at some point, or they have witnessed similar situations. In executive education classes, people relate to the 2008-2009 era, and they think both as airline customers as well as employees of their companies that were trying to weather the storm, and so they were subject to similar initiatives. Sometimes they worked out, sometimes they didn't.

The problem here is the tension we tend to have in all similar situations: If we don't do anything the company is going to die. Are we willing to give away our identity and to change the way we do business to keep the company alive, or not? That's the first order question. The second order question is, is this going to work? It didn't in the past, so is this going to work this time? What are we going to do differently this time?

Kenny: I'm curious also, your area of focus and research deals with CEO compensation and measurement. How do you think about a CEO at a place like RegionFly in this context? How do you lead an organization through something like this?

Gallani: It's fascinating that you're asking me this question, because I have been in situations like that. Not as a CEO, but that I observed. It is very important to keep in mind that you have three main constituencies. You have your customers, you have your employees, and you have your owners, your investors. You have to take care of all three elements. The question is not how you weather the storm, it's not just that. The problem is how you weather the storm and come out swinging. The long-term focus has to be not just survival, but how do we come out of this rough patch in a position where we can regain our place in the market and we can get back to where we were, if not even better.

Kenny: When you talk about measurement in that context, I would imagine most CEOs would say, "Look, you can't peg me to quarterly earnings. This is about a bigger, longer-term thing."

Gallani: Yes, and it's very difficult to sell that to your investors. It's very difficult to sell that to yourself. Obviously you don't know when it's going to end, and so you need to put together a strategy, which is already a very challenging activity per se, with a lot more uncertainty than normal. There is a little bit of the selfish part of people that says, "Well, but my quarterly bonus is important to me." There is a lot of trade-off between short-term decisions and long-term decisions that need to happen, and that makes that job particularly difficult and well paid.

Kenny: We don't know what the future holds for RegionFly. This question is left hanging, and that's part of what the classroom discussion is all about. I guess I'm wondering, from your perspective, is there going to be a future golden age that we can look to in the airline industry? Is this something that we can expect to ever get back with some level of consistency?

Gallani: In the industry? I don't think the airline industry will actually die anytime soon, because we still travel a lot despite having other means of communication. If you think about the economic crisis, a lot of companies reduced dramatically their travel activities, but they kept communicating via video calls or other devices made available through technological advancements. We still fly a lot. It's still a very...

Kenny: A dicey endeavor, I think.

Gallani: It’s a convenient way of going places. I don't think the airline per se will die anytime soon, but they are certainly facing a lot of challenges. Geopolitical unrest and changes in demand, changes in the price of inputs. Think about changes in the jet fuel prices, or the type of airplanes and the maintenance and the technological advancement of the aircrafts per se.

Kenny: We look forward to the B-case on RegionFly to see if they survive. Susanna, thank you for joining me.

Gallani: Thank you for having me. This was fun.

Kenny: You can find the RegionFly case, along with thousands of others, in the case collection at HBR.org. I'm Brian Kenny, your host, and you've been listening to Cold Call, the official podcast of Harvard Business School.

Brian Kenny: Ah, the golden age of air travel, when giants like Pan Am and TWA ruled the skies, people dressed up for their flights and lined up for photos before boarding, when the government set the price for tickets, and the only way to compete was on customer service. Cue the free booze and real china. Then along came deregulation in 1978 and everything changed, but not necessarily for the worse. Deregulation created price wars and tickets dropped an average 30 percent--but those airlines that distinguished themselves on premium service had to chart a new course.

Susanna Gallani's research focuses on issues related to the design and effectiveness of incentives, including CEO performance and measurement systems linked to compensation contracts. Thanks for joining us today.

Susanna Gallani: Thank you for having me. It's a pleasure.

Kenny: I loved this case, the golden age. We always look at these things through rose-colored glasses. I'm sure that air travel in the golden age probably wasn't that great for a lot of reasons, but I think people will be able to relate to this case because we all travel, we all have our own experiences. Let me just ask you to begin by setting up the case for us. Who are the protagonists and what's going on?

Gallani: We are catching these two protagonists at the moment where they have to make a very serious recommendation that might impact the future of the company. They are at a crossroads. They have tried to keep this company alive in some ways, facing economic downturn challenges and changes in their market structure, changes in their clientele. They are at the point where they're really looking ahead and not seeing the picture that they want to see. They have been asked to provide a recommendation as to whether they should cut one more of the remaining five routes that this airline serves in order to control costs and get back to profitability. They have been tasked by their new owners, because this company has recently been acquired, to make a recommendation. They're struggling with it because there are obviously serious implications.

Kenny: I should say for our listeners at the outset, this is not a real company. Why did you choose to do it that way?

Gallani:We really wanted this case to be appealing to a large audience and serve for many purposes at many different levels of education. We thought that providing a clean setting that is realistic enough but not confounded by all the other things that we find in our messy truth, it was an effective way to do it.

Kenny: Describe RegionFly for us. What's their evolution and how did they make their mark in the world?

Gallani: RegionFly was founded in the early '70s, so at the tail end of what you described in your introduction as being the golden age of air travel, where travelers who would choose flying as their means of transportation would be a small portion of the population, very wealthy, willing to pay a high price tag for the experience. It was a very glamorous outlook on the airline industry.

RegionFly started off at the tail end of that time, an interesting time because it comes between those two historical landmarks. One is the golden age of air travel we just discussed, and the other one is the other event that you mentioned in your introduction, which is the deregulation in '78. They start off on a very good note where the market is ready, there is a clientele for their service. They operate in a very small niche of the market, and they serve premium air travel services in a very small range of routes. They have an established clientele that knows what they're getting, and they're willing to pay the higher price tag for the type of service they're getting.

Now, '78 comes along and things change dramatically for this company, but because their original CEO, who was the founder, had this very clear strategy in mind of keeping their size small and focusing on quality, focusing on value for their customers, actually weathered the storm for a long time. It is only in the 2008-2009 time where things really fall apart. The entire airline industry had been hit pretty hard, and certainly luxurious services like premium air travel were among the first things to go. Now they are in the situation where they're trying to keep their company alive, but they have to deal with a completely different market structure and type of clientele.

Kenny: And a lot of other forces are coming to bear at that time. In a post-recession world we all experienced cutbacks in travel budgets. Business class became sort of a thing of the past, airlines were introducing more technology so maintenance costs went up, all those sorts of investments go up. In better times, what was the culture at RegionFly like?

Gallani: It was all about the service. They would go all the way, without considering too much the cost implications, because they had a clientele that was willing to pay the price. They were not necessarily a frugal company, by any stretch of the imagination, but they were very focused on providing value for the price.

Kenny: Probably a certain sense of pride that went along with working there. What was it like to work at RegionFly in the good days?

Gallani: It was all about distinguishing themselves from others because they were better, because they were providing this higher level of service, and they were very, very focused. Being a small company, you can imagine there was a lot of a family feeling--we're in this together. They were all driving in the same direction.

Kenny: I think there are many things you could relate this to outside of the airline industry, because many firms establish themselves and their brands as a premium brand of one sort or another. We work at Harvard Business School, I guess we fall into that category as well. How does this relate in your mind to other industries?

Gallani: The example of Harvard Business School is a very fitting one, because we strive to provide a high level of service and a high level of quality to our customers and to our students, and that comes at a cost. Sometimes it is difficult to justify the high price tag if you're not aware of the type of value you're getting for your money.

Kenny: RegionFly brings in some consultants, what do the consultants tell them?

Gallani: The recommendations they're bringing along are, first, cut costs across the board, which we have all heard at some point in our lifetime somewhere. The other recommendation is to identify a minimum threshold of profitability for their different routes, the different services they're offering, in order to identify candidates for elimination.

Now, these two recommendations, we really want our students to attack them and discuss them in detail because they have serious consequences.

Kenny: Dive into that a little bit for me. Cost-cutting is at the core of the brand. If you do that, aren’t you gutting the brand.

Gallani: Exactly. By cutting costs across the board, and the type of cost-cutting they are proposing, really goes into the amenities and the little things that make the flying experience better. I don't know if you have experienced this in your flight history, but I know that at some point we saw, when you were traveling with certain larger airlines across the Atlantic, a little bag of amenities would be given to you--and then suddenly they weren't there anymore. Now, is that going to change dramatically the quality of the flight? Maybe not, but customers notice that. When you charge a customer a very high price for a service that comes across as not keeping your end of the deal. That might have implications on their customer base, and some customers might decide that they are not willing to pay the high price tag anymore.

Kenny: There are some airlines who have staked their brand on the opposite extreme. I forget which one it is that charges people to use the restroom. They're charging for baggage, they're charging for every little fee. Can RegionFly credibly move in that direction, or would that be...

Gallani: That would be a complete distortion of their culture and the way they do business, which is part of the reasons why the employees of the company don't like these recommendations that the consultants are bringing along.

Kenny: The changes that are being recommended here are going to fundamentally change the experience of working for a place like RegionFly. How does an organization deal with these kinds of recommendations that come from outside, frankly, that maybe the consultants don't understand us? Does this come up in the classroom discussion at all?

Gallani: It does. It does, because there is this huge tension underneath this decision, and whether to go with the recommendation of the consultants or not will dramatically change the way people work there, the type of priorities they have. There is obviously resistance toward this, people coming from the outside that have not been here all along, and it seems now it's all about the money. That's one problem.

The other problem is that we're talking about cost-cutting, and in general, employees, when they hear those words, start worrying about their own job, or the survival of the company more broadly. The first implementation of similar measures had been done in the past, and people got a little bit excited because these were portrayed as measures that would actually save the company and make things better for the future. Now we're facing a situation in which they didn't work.

The question on the table, at the point we position the case, is should we do it again? Is the problem that we didn't do it aggressively enough, or is the problem that we really made the wrong decision and we should do something else? That is the question at the core of the problem that the CFO and the chief of strategy are facing.

Kenny: Now, we talked a little bit before about the tensions in the classroom and how this surfaces. How do students react to this? I'm curious a little bit about the difference how an MBA student thinks about it and how an executive education student might think about it.

Gallani: First of all, the reason we provided this cleaner, simplified setting is to help undergraduate students grapple with business situations that they might not have been exposed to just yet. The undergraduate students try to focus more on the big signals and the big problems. When you teach this case in an MBA class or an executive education class, you get an enormously rich discussion because everybody has faced similar problems some way, at some point, or they have witnessed similar situations. In executive education classes, people relate to the 2008-2009 era, and they think both as airline customers as well as employees of their companies that were trying to weather the storm, and so they were subject to similar initiatives. Sometimes they worked out, sometimes they didn't.

The problem here is the tension we tend to have in all similar situations: If we don't do anything the company is going to die. Are we willing to give away our identity and to change the way we do business to keep the company alive, or not? That's the first order question. The second order question is, is this going to work? It didn't in the past, so is this going to work this time? What are we going to do differently this time?

Kenny: I'm curious also, your area of focus and research deals with CEO compensation and measurement. How do you think about a CEO at a place like RegionFly in this context? How do you lead an organization through something like this?

Gallani: It's fascinating that you're asking me this question, because I have been in situations like that. Not as a CEO, but that I observed. It is very important to keep in mind that you have three main constituencies. You have your customers, you have your employees, and you have your owners, your investors. You have to take care of all three elements. The question is not how you weather the storm, it's not just that. The problem is how you weather the storm and come out swinging. The long-term focus has to be not just survival, but how do we come out of this rough patch in a position where we can regain our place in the market and we can get back to where we were, if not even better.

Kenny: When you talk about measurement in that context, I would imagine most CEOs would say, "Look, you can't peg me to quarterly earnings. This is about a bigger, longer-term thing."

Gallani: Yes, and it's very difficult to sell that to your investors. It's very difficult to sell that to yourself. Obviously you don't know when it's going to end, and so you need to put together a strategy, which is already a very challenging activity per se, with a lot more uncertainty than normal. There is a little bit of the selfish part of people that says, "Well, but my quarterly bonus is important to me." There is a lot of trade-off between short-term decisions and long-term decisions that need to happen, and that makes that job particularly difficult and well paid.

Kenny: We don't know what the future holds for RegionFly. This question is left hanging, and that's part of what the classroom discussion is all about. I guess I'm wondering, from your perspective, is there going to be a future golden age that we can look to in the airline industry? Is this something that we can expect to ever get back with some level of consistency?

Gallani: In the industry? I don't think the airline industry will actually die anytime soon, because we still travel a lot despite having other means of communication. If you think about the economic crisis, a lot of companies reduced dramatically their travel activities, but they kept communicating via video calls or other devices made available through technological advancements. We still fly a lot. It's still a very...

Kenny: A dicey endeavor, I think.

Gallani: It’s a convenient way of going places. I don't think the airline per se will die anytime soon, but they are certainly facing a lot of challenges. Geopolitical unrest and changes in demand, changes in the price of inputs. Think about changes in the jet fuel prices, or the type of airplanes and the maintenance and the technological advancement of the aircrafts per se.

Kenny: We look forward to the B-case on RegionFly to see if they survive. Susanna, thank you for joining me.

Gallani: Thank you for having me. This was fun.

Kenny: You can find the RegionFly case, along with thousands of others, in the case collection at HBR.org. I'm Brian Kenny, your host, and you've been listening to Cold Call, the official podcast of Harvard Business School.